Top 10 reasons ETF’s are superior to Mutual Funds

By: ispeculatornew
Date posted: 10.12.2009 (5:00 am) | Write a Comment  (22 Comments)

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calculatorOver the past few months, I have not been shy about my preference for ETF’s over mutual funds and how eventually I would expect ETF’s to take away a lot of the funds under management currently invested in mutual funds. I was having a good discussion with my friend Mike from TheFinancialBlogger and while he had good points, I remained convinced that in almost all cases, ETF’s are a better product for the investor. We finally agreed not only to disagree but to voice our arguments in writing on our blogs. So after reading this post, you can go on TheFinancialBlogger and read Mike’s arguments in favor of mutual funds. I’m still having trouble believing he thinks mutual funds are superior (will explain later) but it should be interesting to see what he can come up with You can read his post about ETFs vs. Mutual Funds.

Just before starting, I will point out a few differences between the two:

-Mutual funds are basically funds that investors can buy units of. Investors buy the units directly from the fund manager and can then sell the units at any point on time in the same way.

-ETF’s are similar funds but they are traded on stock exchanges and can be traded at any time of the day.

So here we go, the top 10 reasons ETF’s are superior to mutual funds

10-Trade at any time: Why would you settle for a mutual fund where you can only trade at the end of each day. If at noon you see market crashing and want to get out, with a mutual fund you are out of luck. You will send an order, but will only get the end of day price!

9-Rebalancing: As the market and the economy changes, you will likely want to change how you allocate your investments, perhaps putting more emphasis on fixed income or on emerging markets or simply scaling back into safer, less volatile funds. Guess what, with an ETF, you are about 2 clicks away from changing your asset allocation. With mutual funds? Well, first start by calling the managing company, explain what you want and hope that it is possible without too many extra fees!

8-Do like the big guys: Do you think it just happens to be that big institutions and brokers do not invest or trade mutual funds? Think it just happens to be that the only thing they do is sell them? They do not want to pay more, have less flexibility, etc. ETF’s on the other hand are getting huge institutional volume because they are liquid, cheap and easy to understand.

7-Transparency: Ever wondered what exactly is happening inside the mutual fund you purchased? Well, with some luck, you will be able to see the biggest positions that were held in your fund at the end of the last quarter. No, not all of them, not the cash, but the bigger positions, usually the top 5. Compare that to ETF’s. On any given day, you can see exactly what is in each share, which positions, how many, and how much cash. To me, that feels a lot more transparent

6-No entry or exit conditions: Many mutual funds carry conditions. You must invest a minimum, or commit to regular investments. You have to remain invested for a given period of time or pay a penalty, etc. Again, ETF’s do not have such conditions, you can buy and sell in a minute, a month or a year, it makes no difference, you are FREE!

5-More options: ETF’s offer almost unlimited possibilities. You can buy positions on sectors, commodities, bonds, inflation protected bonds, target specific countries or regions, etc. Generally, mutual funds are less flexible and usually are only used to track specific equity indexes or do active investing compared to an equity benchmark.

4-Strategy flexibility: You want to trade on margin when buying ETF’s? Or do you want to do an options strategy to limit your downside during a crash instead of selling the whole investment? Maybe you were thinking of having a short position for a little while? Good luck doing those things with mutual funds, they are pretty much impossible. But with ETF’s? Easy!

3-Tax Efficiency: As you get closer to retirement and assets grow, the important of tax efficiency in your investments takes a growing important. For various reasons, ETF’s are much more tax efficient! There are many reasons for this. One of them is that with mutual funds, every time an investor buys or sells shares, the total number of shares changes. Because of this, there is a lot more trading “inside the fund”. For example, if investors sell an important amount of shares, the fund will have to sell shares from their index, while will cause capital gains taxes. If those same investors come back to buy, the fund will get back to that initial quantity but will have paid more taxes. On the other hand, ETF’s have less problems because investors selling will be selling to other investors so the underlying index owned by the ETF company is not affected. Over time, this has an effect on the return.

2-Commissions: Most mutual fund buyers are convinced to do so by sales people or financial advisors. Wonder why? Commissions!!! They actually get an annual commission in most cases on your assets. So it’s a good deal for them… You pay a little more fees, but they get more commissions, win-win right? Oh except you are the loser!

1-Less Fees: Mike’s argument will be that you have to pay a commission on every ETF trade while every mutual fund transaction does not carry fees. That is true of course, but considering a 3000$ investment, the commission of 10$ from a standard broker represents .33%. Mike actually asked me to compare an ETF (XIU) with a mutual fund that tracks the same index from Altamira. They had a .40% fee difference. So even keeping that investment for one year will make you a winner. Imagine if you keep the investment for 10 years… you will end up saving .40% annually!!!

Let’s get to the point though.. all of these arguments are great but numbers only will close the debate right? Then, here are some numbers! Over 5 years, these are the returns of the TSX60, and the two funds:

SPTSX60              =        56.73%
XIU                        =        55.70%
ALTAMIRA        =        52.80%

Do you even need to hear more? Didn’t think so. Case closed! 🙂 You can still take a look at Mike’s post about ETFs vs. Mutual Funds 🙂 And also, be sure to read about the 6 things to look at when selecting an ETF.

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22 Comments

  1. […] to write a post about ETF and Index Mutual Funds to see which one is best. (You can read the Top 10 reasons why ETF’s are superior to Mutual Funds by Intelligent […]

  2. Comment by Frank — October 13, 2009 @ 7:02 am

    I totally agree with you. It’s one of the best posts I’ve read in a while.

    3 biggest advantages for me: lower MER, better asset allocation and better flexibility.

  3. Pingback by Saturday Freebies. Do What You Will — October 16, 2009 @ 10:03 pm

    […] 10 reasons ETFs are superior to mutual funds. Don’t believe him? Check out ETFs vs index mutual funds: the ultimate battle! […]

  4. Comment by Gary — October 20, 2009 @ 7:09 am

    While I agree with most of this, I don’t agree with #8. I have several ETFs, and my main concern is the very low volume of daily trade in them. The concern is how easily they’ll sell when I want to sell. The big guys don’t seem to trade in ETFs or mutual funds.

  5. Comment by IS — October 20, 2009 @ 8:24 pm

    actually, it really depends which ones. I think it’s important to consider that when picking an ETF but many ETF’s trade millions and tens of millions per day.. just take a look at XLF, USO, SPY, GLD for example

  6. […] is no secret by now, I am a fan of ETF’s (especially when compared with mutual funds) and I have discussed in the past how fixed income ETF’s have been receiving very important […]

  7. Comment by ron — October 23, 2009 @ 7:29 am

    I think you are wrong:
    #10 trade anytime is counter productive to a buy and hold mentality. Too many transactions will surly lead to losing money.
    #9 rebalancing via 2 clicks, leads to buy and sell transactions all too frequently better to wait and rebalance yearly if required.
    #8 the big guys are too busy to take the time and build portfolios, they are just buying the index to have the prescribed asset allocations because that’s their mandate. we little guys pay real money and take the hit personally to buy and sell unlike the big guys
    #7 transparency is meaningless. I submit that less than 1 in 100,000 Canadians know what stocks are in the tsx index must less know their weighs by market cap! Since they departed from the tse 300 I don’t even know how many stocks are in the tsx index, do you? I know that people can look it up on bloomberg or some other service but do they? In this way the index etfs are just as transparent as any equity mututal fund.
    #6 there are no entry or exit conditions for efts or no-load mutual funds, just capital gains/losses butg efts have commissions, most fund families do not.
    #5 more options than thousands of mutual funds, with multiple fee structures? I think not.
    #4 flexibility to sell short, buy on margin or trade partial positions seems to me as easily done with efts and mutual funds. There bear funds for short sellers. You can borrow to go long on funds. You can buy or sell exact dollar amounts or units of funds. Besides if you are doing these things you had better be very knowledgeable and have a very high investible asset level, so yes I agree you may not want to use efts or mutual funds in these cases.
    #3 tax efficiency clear belong on the side of corporate class funds not to efts
    #2 commissions are paid every time you buy or sell etfs, especailly if you reinvest all dividends you must buy and sell in tiny amounts, so the commissions can be quite high. Mutual funds do not always pay commissions, it depends on their structure, in almost all cases they do not charge to buy and sell in tiny amounts for you to reinvest distributions.
    #1 less fees, sure that’s true, must like the axiom you get what you paid for. The TSX 300 was invested over 33% in Nortel ten years ago. Most actively managed Canadian Value Funds had no Nortel ten years ago. Portfolio managers earn their salaries.

  8. Comment by Zavi — October 23, 2009 @ 12:47 pm

    Interesting debate…

    Ron- I do not agree with you with some points.

    #10: It is not counterproductive. You have the possibility to trade anytime, not the obligation to trade anytime.
    #9: You do not necessarily need rebalancing everyday, rebalancing can be quarterly or yearly…
    #8 I would say it depends, but “trend is your friend”. Do not go against the big guys… Talking about liquidity of an ETF, this is mainly affected by the liquidity of the underlying stocks or bonds in its index – not the trading volume of the fund itself (like any mutual funds)
    #4 You can only buy mutual funds in long positions. There is no day trading available for Mutual Funds.
    #3 ETFs are more tax-efficient. You can measure the Morningstar’s tax-cost ratio, for any corporate class fund.
    #2 some brokers impose a commission to buy or sell no-load mutual funds. Other so-called “no transaction fee” mutual funds don’t charge a commission, but may carry higher expense ratios….

    Conclusion: Of course, each kind of investment has its strengths and weaknesses… it depends of your tolerance of risk, and if the fund objectives match your financial objectives, etc. It seems to me though that ETFs have better tax efficiency, lower fees/total ownership costs.

  9. […] Speculator and I wrote 2 articles comparing ETFs to Index Mutual Funds (you can read why ETFs are superior to mutual funds by IS or why index mutual funds may be the right solution sometimes, written by me. However, there is […]

  10. […] a Canadian would like to invest in the broad US equity market, what is the best way? Of course, I will suggest using ETF’s. But there are two main choices if investing in the S&P500, the main stock index in the […]

  11. Comment by Jake Sully — January 12, 2010 @ 8:26 am

    I own several ETFs but there is really only 2 reasons: Low Fees and trade flexibility.

    Several of the authors other reasons are moderately flawed:

    10 – you are promoting intra-day trading? this is a poor investment strategy that will incur unneccessary costs actually making the daily/hourly cost of owning an ETF inferior to a mutual fund.

    9 – rebalancing equally easy with both ETFs and MFs

    8 – Do like the big guys? Not really a reason. Mutual Funds are for retail investors.

    7 – transparency is nice, but do you really think you can identify which security in your mutual fund your seasoned and accredited portfolio manager goofed on BEFORE it drops in value?

    6 – Minimum hold period condition an issue? Again you are promoting day-trading. I think Buffett said you have no business in the equity markets if you don’t have a minimum 10 year time horizon, so holding a fund for a couple months shouldn’t faze you if you do proper fund selection.

    5 – Mutual funds also have unlimited possibilities plus tools for increasing cash flow and reducing tax (corporate tax funds).

    4 – You can own mutual funds and use options to mitigate risks. These are not mutually exclusive.

    3 – Tax efficiency? Look to corporate class mutual funds for lucrative tax deferrals not available in ETFs

    2 – Commissions are paid for investors who need advice from a licensed professional. DIYers can buy no-load funds.

    1 – I agree – low fees are great. Unless you are daytrading and incurring unnessessary commissions (both in and out) as advocated by the author. There are no trading costs to buying and seeling mutual funds.

    Again, I like ETFs for low fees and flexibility, but the author has spun this article in a direction I disagree with.

    Jake S

  12. Comment by IS — January 17, 2010 @ 8:54 pm

    @Jake

    Hi Jake, great comments, here would be answers!

    10-Not necessarily promoting intra-day, but rather promoting the ability to get out of a position during the day instead of at day’s end only
    9-Ok, could give you that one
    8-Not to do like the big guys, but rather, I would argue that if the big guys are not buying mutual funds, it is because of the excessive fees, that counts as an argument in my opinion
    7-no, but I like the fact that I can recompute performance, see what is happening in the ETF in terms of fees, etc.
    6-Some mutual funds have minimum holding periods of several months, sometimes 6 months, I would hardly call that intraday. Sure most holdings are for the long term, but having penalties when getting out after a few months is wrong
    5-Sure, but as times goes by, I think ETF offer more possibilities. For example, an ETF on volatility can be useful, as can one on silver.. There are many other examples but I doubt you would find a mutual fund for those 2.
    4-Yes, but the options will not have the exact same underlying
    3-This point I am not 100% certain, there are a million different opinions but most of those I have read support the fact that in general, ETF’s are more tax efficient.
    2-Those no-load dfunds still carry tons of annual fees

    Thanks for your opinions Jake though, a lot of very good points

  13. […] about ETF’s and a strong negative one about mutual funds. And yes, I did write about why ETF’s are superior to mutual funds. Some would argue and some points are a bit tougher to debate but in general, I do not see how […]

  14. […] I have been a major supporter of ETF’s, especially when compared with mutual funds alternatives. Two of the main reasons are how transparent they are and because of their low fees. Yesterday, […]

  15. […] many of you know I am a big fan of ETF’s for many reasons but the amazing variety of ETF’s now makes it possible for almost anyone to […]

  16. […] becoming a tendency that is sure to make customers very happy. Why? Because the battle of ETF’s vs Mutual Funds is entering into a new phase. Some time ago, brokers were still mostly fighting ETF’s by […]

  17. Comment by N. Katz — December 1, 2010 @ 3:33 pm

    IS largely misses the points made by TFB. This limits the value of his post substantially.

    TFB’s major point is that in one particular scenario — a very important an prevalent one, namely, ordinary retirement savings — index mutual funds are probably a better way to go than ETFs.

    The first reason is the lack of trading commissions. IS tries to counter this by pointing out that a $10 trading commission on a $3000 investment is a very small fraction, and can be made up quickly by lower management fees. But that’s an unrealistic straw-man example. A more realistic scenario, in the retirement savings universe, is a worker who sets aside $500 every two weeks — and might want to allocate that $500 between two or more funds (one stock and one bond fund, for example). In such a case, setting up automatic mutual fund contributions at each payday is a very good idea, because the investor can invest in increments of $250 each time the money comes in. Trading ETFs to achieve the same result would incur $20 of commissions for each $500 contribution — a substantial cost. The only way to avoid that is to allow the contributions to accumulate at 10 week intervals and then invest $3000 at a time to invest in a single ETF. Another 10 weeks would go by until he could invest in his second fund economically. A lot of money sits around idle for a lot of weeks, dollar cost averaging opportunities are missed, and the portfolio spends a lot of time out of balance (at least in its earlier and smaller years, where each buy represents a large fraction of the whole), which is non-ideal, and the investor will probably have to make each ten week trade manually, which is a chore one can easily neglect.

    Which leads to the second point — the plethora of choices and minute-by-minute trading opportunities is more likely to be misused by the average investor than used to great advantage. Sell out as the market is tanking to avoid further losses? Really? When the average investor has a day job and cannot constantly monitor the markets? And even if you are constantly tuned in, would selling out halfway down the “flash crash” have helped, when the very next day the market had fully recovered to pre-crash levels?

    For most people who put away long-term savings incrementally, the ability to set-and-forget one’s mutual fund savings settings, and have those transactions go through very cheaply, is an unbeatable advantage.

    (By the way, several of the other pro-ETF arguments are largely spurious. Management fees on index mutual funds are higher, but not by much; not nearly as bad as in actively managed funds. Broker commissions are a dirty industry secret, but they come out of fees, so your last two points are really one; moreover, cheap index mutual funds tend to pay the least in kickbacks anyway. Transparency is also a spurious point in the case of index mutual funds, because you DO know the holdings — the index the fund is tracking; again, the point is a lot more relevant to actively managed funds. ETFs may be tax efficient, but anyone holding through a tax-advantaged account, such as U.S. savers with their IRAs, shouldn’t particularly care.)

  18. Comment by N. Katz — December 1, 2010 @ 3:39 pm

    P.S. Rebalancing does not need to be done by most savers more than once every couple of years, and can be done pretty easily with most traditional mutual fund setups. If one’s portfolio consists of two or three broad funds (two stock funds and a bond fund, say), rebalancing can be accomplished, if the funds are issued by the same company, by a set of nearly free internal transfers. If the funds are not with the same company, it can by skewing contributions for several months going forward to achieve the right balance. Only if one holds a relatively large number of different funds with different companies does it become either more expensive or cumbersome to accomplish an adequate rebalancing.

  19. Comment by IS — December 3, 2010 @ 4:51 am

    @N. Katz – Just to confirm, this was written before seeing TFB;s post, we decided to write on the subject but I was not responding to his points:)

    -When you talk about your investor who invests 500$ per 2 weeks, here is how I would respond:

    -Such an investor would rather quickly reach $100,000 in assets right? At that point, he would be paying over $1000 in additional fees per year (based on a 1% commission higher than on ETF’s, which sounds reasonable right?). That is 40$ per 2 weeks… isn’t that similar to paying a commission? When an investor has less assets, I think waiting to have $2000 to invest before buying the ETF helps a lot in diminishing these fees.

    I spoke to a Fidelity representative which told me that the average fee on their funds right now is 2.14%. Considering that over 99% of ETF’s charge less than 1%… I think it’s fair to say the difference is significant.

    And yes, a lot of my other points relate not necessarily to long term index investors but rather investors in general.

    Thanks for the good comments, I think the debate will go on for a long time but assets are moving rather quickly from mutual funds to ETF’s so I would think that will force mutual funds to diminish those fees and make the competition more equal (Fidelity’s 2.14% average fee is actually 0.30% better than a year ago or so).

  20. Comment by ruaninvestor — March 15, 2011 @ 6:17 am

    I agree with most of this, I don’t agree with #8. I have several ETFs, and my main concern is the very low volume of daily trade in them.

  21. Comment by IS — March 15, 2011 @ 9:22 am

    @ruaninvestor – it of course depends on each one but I would say that the main ETF’s do have more than enough volume to get you decent liquidity.

  22. […] that we are very much in favor of ETF’s. They are not perfect but we do think that they are superior to mutual funds as you can read about here. The basic arguments are […]

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